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Accrual Accounting Process

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Accrual Accounting

Process

15.501/516 Accounting

Spring 2004

Professor S. Roychowdhury

Sloan School of Management

Massachusetts Institute of Technology

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What is Cost of Goods Sold?

Q Mart buys $10,000 worth of cereals from Special Foods for cash.

Assets = L + OE Cash Inventory

-10,000 +10,000

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3

What is Cost of Goods Sold?

Q Mart sold one-half of the cereals for $8,000 cash Assets = L + Owners’ Equity

Cash Retained Earnings +8,000 +8,000

(4)

What is Cost of Goods Sold?

The cost to Q Mart of buying the cereal that was sold for $8,000

one-half of $10,000 = $5,000

= Cost of Goods Sold or Cost of Sales Assets = L + Owners’ Equity

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What is Gross Profit or Margin?

Assets = L + Owners’ Equity

Cash Inventory Retained Earnings -10,000 +10,000

+8,000 +8,000

-5,000 -5,000 Increase in retained earnings +3,000

Gross Profit or Margin = Sales Revenue (-) Cost of Goods Sold = $3,000

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Components of Income

Sales or Service Revenue (-) Cost of Goods Sold

(-) Operating Expenses

(-) Unusual or Infrequent items (-) Income Tax Expense

= Income from Continuing Operations (ICO)

All items disclosed below ICO are referred to as “below the line” items.

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Components of Income - Staples

Sales 11,596,075

Cost of goods sold&

Occupancy costs 08,652,593

Gross Profit 02,943,482

Operating expenses

Operating &selling 01,795,428

Pre-opening 00,008,746

General & administrative 00,454,501 Amortization on intangibles 00,002,135

Amortization on goodwill 0

Asset impairment charges 0

Store closure charge 0

Interest & other expenses 00,020,609

Total operating & other expenses 02,281,419

Income before taxes 00,662,063

Income taxes 00,215,963

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Cash Flow Statement

Operating Activities

Net income 0,446,100

Adjustments,

Depreciation and amortization(+) 0,267,209

---Cash flow from operating 0,468,250

Investing activities

Acquisition of property & equip (-) (0,264,692)

Acquisitions of businesses (-) (1,171,187)

---Net cash from investing (1,436,226)

Financing activities

Proceeds from sale of capital stock (+) 0,078,895

Proceeds from borrowings (+) 0,730,897

Payments on borrowings (-) (0,95,235)

---?

Net cash from financing 0,714,083

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Cash Flow Versus Accrual

Accounting

Cash flow accounting

Measures performance by comparing the cash inflows of a certain time period to the cash outflows of that period (e.g., cash flow from operations).

Accrual accounting

Measures performance by comparing revenues (which are recognized when the earning process is complete) with expenses (which are recognized when assets are

consumed or liabilities are created).

Geared toward periodic performance measurement that is not skewed by investment, financing, and long-horizon

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Cash Flow Versus Accrual

Accounting

Accrual accounting

Based not only on cash transactions but also on credit transactions, barter exchanges, changes in prices,

changes in form of assets or liabilities, and other transactions.

records events that have cash consequences for an enterprise

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Cash Flow Versus Accrual

Accounting

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Over the entire life of a corporation, total “income” under cash flow and accrual accounting is the

same.

However, cash receipts in a particular period may largely reflect the effects of activities of the

enterprise in earlier periods.

Similarly, many of the cash outlays may relate to activities and efforts to be undertaken in future periods.

The matching principle in accrual accounting

(12)

Cash Flow Versus Accrual

Accounting

Stock price = Present value of expected

future cash flows.

Changes in stock prices = f(changes in

expectations about future cash flows).

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Cash Flow Versus Accrual

Accounting

What cash flows are important?

Future cash flows!

When compared to current cash flows,

current earnings more highly associated with

future cash flows

When compared to cash flows, earnings have

a stronger association with stock prices.

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Accounting Earnings versus

Stock Prices

Top management’s incentive compensation is

usually linked to stock prices and accounting

earnings.

Why not link it to stock prices alone?

Stock prices are affected by economic factors that are outside of a manager’s control (e.g., macroeconomic, political factors).

Consequently, stock prices may be a poor indicator of managerial performance.

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Accounting Earnings versus

Stock Prices

A second reason for using accounting earnings Expected versus delivered performance

Firm X hires manager Y on December 31, 1997. Stock price of X jumps by 10%! Why?

Market’s expectations regarding the company’s future performance improve.

Accounting earnings of 1998 increases by 10%!

Why?

Manager Y’s actions produce an actual improvement in the financial performance of X in 1998. Stock prices

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Accounting Earnings versus

Stock Prices

By combining stock prices and earnings to

reward managers, a firm can reward a manager

for his/her strategic planning and operational

execution.

Of course, stock prices do reflect the

delivered

performance of the manager as well.

But if payment is on the basis of expected

performance, then what do you do if the manager shirks subsequently? (Moral hazard problem)

Earnings provide a straightforward measure of

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Accrual Accounting and

Periodic Adjustments

Accountants record exchange transactions.

But this does not capture all economic activities. Periodic adjusting

Required to record activities that have taken place, but which have not yet been recorded.

To reduce accounting costs

(18)

Recall Joe’s Landscaping Service

Company pays $9,000 for expenses (wages, interest, and maintenance)

Assets = Liabilities + Owners’ Equity

Cash Retained Earnings

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Recall Blockbuster - Matching

Year1

Year2

50x 17x

How much does Blockbuster recognize as an

expense each year?

50

17

67 67

($20)

($20)

Yearly

Expenses

$15

$5

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20

Recording video expenses

Retained Earn.

Cash

Video Asset

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20

Buy Video

Rent 50x

@$3each

End of Y1

Rent 17x

@$3each

End of Y2

150

51

150

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(15)

51

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Accrual Accounting and

Periodic Adjustments

In many cases, assets and liabilities are

created or discharged without the occurrence

of a visible documentable exchange

transaction

Interest is earned continually on a bank savings account as time passes

Machinery depreciates as it is used in a company's operations.

Periodically, adjusting journal entries are

made to record these effects.

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Accrual Accounting and Periodic

Adjustments

Adjusting entries

Made whenever financial statements are prepared. Why?

Adjusting entries are designed to

Correctly compute periodic income

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Periodic Adjustments

Characteristics of an adjusting journal entry:

matching of expenses and revenues

involves at least one temporary (revenue,

expense, or dividend) account and at least one permanent (asset or liability) account.

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s

Four ways that recognition and

cash do not coincide

Time

Balance Sheet Date

Pay Cash

Recognize Expense

Time

Balance Sheet Date

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25

s

Four ways that recognition

and cash do not coincide

Time

Balance Sheet Date

Receive Cash

Recognize Revenue

Time

Balance Sheet Date

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26

Types of Periodic Adjustments

Expense or Revenue

before

Cash

Expense

incurred

today, but cash paid tomorrow.

Salary earned by employees but not paid at the end of accounting period.

Employees earn salary when they perform their duties, not when they receive payment.

Unpaid salary is a Salary Payable liability

Revenue

earned

today, but cash received

tomorrow

Interest earned today, but cash received tomorrow. Interest is a reward for lending money, so it is earned with passage of time

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Types of Periodic Adjustments

Cash before

accruing Revenue or Expense

(Cost Expirations or Revenue Expirations)

Cash paid yesterday, Expense incurred today.

1998 rent paid in advance in 1997 Rent paid in advance asset

Cash received yesterday, revenue earned today

Cash advance from customer for services not yet performed Cash advance is Unearned Revenue liability

Matching is the guiding principle in periodic adjustments.

References

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